Over 400,000 people visited Farnam Street last month to learn howto make better decisions, create new ideas, and avoid stupid errors. With more than 100,000 subscribers to our popular weekly digest, we've become an online intellectual hub. To learn more about we what do, start here.

Has Financial Development Made the World Riskier?

It seems to me that monetary policy should be informed by the effect it has on incentives and the potential for greater procyclicality of the system.

In this paper, former IMF economist Raghuram G. Rajan, offers his thoughts on how financial development has made the world a riskier place. If you’re interested in this type of stuff, this is a must read. If you’re not curious enough to read a long paper on finance, I’ve posted various excerpts below that give you a good feel for what’s going on.

Ultimately, he concludes, the incentives of bankers and their willingness to seek out and take tail risks brought the system down.

My main concern has to do with incentives. Any form of intermediation introduces a layer of management between the investor and the investment. A key question is how aligned are the incentives of managers with investors, and what distortions are created by misalignment? I will argue in this paper that the changes in the financial sector have altered managerial incentives, which in turn have altered the nature of risks undertaken by the system, with some potential for distortions.

Therefore, the incentive structure of investment managers today differs from the incentive structure of bank managers of the past in two important ways. First, the way compensation relates to returns implies there is typically less downside and more upside from generating investment returns. Managers, therefore, have greater incentive to take risk. Second, their performance relative to other peer managers matters, either because it is directly embedded in their compensation, or because investors exit or enter funds on that basis.

The knowledge that managers are being evaluated against others can induce superior performance, but also a variety of perverse behavior.

One is the incentive to take risk that is concealed from investors— since risk and return are related, the manager then looks as if he outperforms peers given the risk he takes. Typically, the kinds of risks that can be concealed most easily, given the requirement of periodic reporting, are risks that generate severe adverse consequences with small probability but, in return, offer generous compensation the rest of the time. These risks are known as tail risks.

…A second form of perverse behavior is the incentive to herd with other investment managers on investment choices because herding provides insurance the manager will not underperform his peers. Herd behavior can move asset prices away from fundamentals.

Both behaviors can reinforce each other during an asset price boom, when investment managers are willing to bear the low-probability tail risk that asset prices will revert to fundamentals abruptly, and the knowledge that many of their peers are herding on this risk gives them comfort that they will not underperform significantly if boom turns to bust. An environment of low interest rates following a period of high rates is particularly problematic, for not only does the incentive of some participants to “search for yield” go up, but also asset prices are given the initial impetus, which can lead to an upward spiral, creating the conditions for a sharp and messy realignment.

…This means that if some risks become more vanilla and capable of being offloaded to the rest of the financial sector, the banking system will offload them and replace them with more complicated risks, which pay more and better utilize its distinct warehousing capabilities. After all, investment managers, who have a relatively focused and transparent investment strategy, have a lower cost of capital in financing liquid assets and plain-vanilla risks than banks, whose strategies and balance sheets are more opaque (see Myers and Rajan, 1998).

…Consider the incentive to take on risk that is not in the benchmark and is not observable to investors. A number of insurance companies and pension funds have entered the credit derivatives market to sell guarantees against a company defaulting. Essentially, these investment managers collect premia in ordinary times from people buying the guarantees. With very small probability, however, the company will default, forcing the guarantor to pay out a large amount. The investment managers are, thus, selling disaster insurance or, equivalently, taking on “peso” or tail risks, which produce a positive return most of the time as compensation for a rare very negative return. These strategies have the appearance of producing very high alphas (high returns for low risk), so managers have an incentive to load up on them. Every once in a while, however, they will blow up. Since true performance can be estimated only over a long period, far exceeding the horizon set by the average manager’s incentives, managers will take these risks if they can.

…Would a few enterprising managers not want to buck the trend and, thus, return prices to fundamentals? Unfortunately, few would want to go up against the enormous mass of managers pursuing the trend. The reason is that their horizon is limited. If the mispricing in stocks does not correct itself in a relatively short while, the investment manager will see an erosion of his customers as he underperforms. It takes a very brave investment manager with infinitely patient investors to fight the trend, even if the trend is a deviation from fundamental value. Increasingly, finance academics are coming to the conclusion that prolonged deviations from fundamental value are possible because relatively few resources will be deployed to fight the herd (see, for example, Shleifer and Vishny, 1997, or Lamont and Thaler, 2001).

…When risk-free returns are high, compensation is high even if the fund takes on little risk, while when risk-free returns are low, the fund may not exceed even the minimum return if it takes little risk. Thus, low rates will increase fund manager incentives to take on risk.

…More problematic, however, is that because they typically can sell much of the risk off their balance sheets, they (banks) have an incentive to originate the assets that are in high demand and, thus, feed the frenzy. If it is housing, banks have an incentive to provide whatever mortgages are demanded, even if they are risky “interest-only” mortgages. In the midst of a frenzy, banks are unlikely to maintain much spare risk-bearing capacity. If the returns to originating risk are high, and banks have to keep a piece of every risk originated, they have every incentive to utilize their balance sheets fully when the frenzy is on, rather than buck the trend (and their profitable peers) and keep spare capacity for a potential, low-probability crisis.

He also touches on the government providing liquidity through vehicles such as Quantitate Easing

…There seems to be a presumption in this argument that liquidity infusion is cost-less. It is not. It does impose lower policy rates, sometimes for a considerable duration, and entails a tax on savers and a transfer to those who need the liquidity. The low rates implicit in liquidity intervention also could create their own incentive distortions.

…an unanticipated but persistent low interest rate can be a source of significant distortions for the financial sector, and thence for asset prices.

Raghuram concludes:

Risk never can be reduced to zero, nor should it be. We should be prepared for the low probability but highly costly downturn. In such an eventuality, it is possible the losses that emanate from a financial catastrophe cannot be entirely borne by current generations and are best shared with future generations. Some of the mechanisms for sharing such systematic risks with future generations, such as (defined benefit) social security, are being changed. While there are gains from doing so, and from ensuring their sustainability, we need to ensure that the intergenerational risk-sharing mechanism they offer is not overly weakened. We also need to continue improving the intrinsic flexibility of our economies, so as to better ride out the downturns that, almost inevitably, will occur.